The Internet Taxman Cometh

Online shoppers could soon find themselves paying more for their purchases if state policymakers succeed in convincing Congress to sign off on a multistate sales tax cartel for the Internet.

While America doesn’t have a national sales tax, some state officials have spent the last 15 years scheming to devise a more unified sales tax regime so they can force mail-order and online sellers to collect sales tax for states where they have no operations. And now some in Congress appear ready to lend them a hand with legislation that would bless state efforts to impose taxes on interstate commerce, something usually blocked by the Commerce Clause of the Constitution.

Senators Dick Durbin (D-IL) and Mike Enzi (R-WY) will soon introduce the Main Street Fairness Act, which would force all retailers to collect sales tax for states who join a formal compact. It’s a novel—and regrettable—ploy to get around constitutional hurdles to taxing out-of-state vendors.

State lawmakers and tax officials offer three primary justifications for taxing Net sales, but each argument has weaknesses.

First, states argue that the tax is already owed to them. It’s true that shoppers are supposed to remit “use tax” to the state whenever they buy from retailers who aren’t required to collect the sales tax. But few people voluntarily compute and pay use taxes. States want online retailers to do it because consumers won’t.

Forcing online vendors to collect local taxes would create significant burdens on interstate commerce. There are approximately 7,400 local jurisdictions in the U.S. and different definitions and exemptions further complicate the code. For example, is a cookie a “candy,” (which is taxed in most jurisdictions) or a “baked good,” (which is typically tax-exempt)?

The Supreme Court prevents states from imposing collection obligations on interstate commerce because of these burdens. The Court’s rulings stipulate that only retailers with a physical presence (or “nexus”) within a taxing jurisdiction are required to collect and remit sales taxes. If an online retailer has a store in the state, it qualifies as sufficient nexus for the state to demand tax collection. By contrast, if an official or salesperson from the online company visits the state just for a day, that’s not enough to establish nexus.

States have been trying an end-run around the high court through the so-called “Streamlined Sales and Use Tax Agreement” (SSTUA). This 200-page “simplification” effort remains a Swiss cheese tax system, however, riddled with loopholes and complexities that could burden vendors, especially mom-and-pop operators.

A 2006 PricewaterhouseCoopers study found that sales tax compliance costs for small retailers (less than $1 million in sales) equaled almost 17 cents of every dollar they collected for states. Expanded tax collection obligations could increase that deadweight economic burden and discourage marketplace innovation and new entry.

To remedy that, states have considered a “small seller” exemption. But states will not commit to protect small sellers or compensate retailers for new collection burdens.

While they wait for Congress to act, several states have attempted to extend collection mandates through “affiliate” taxes -- known generally as the “Amazon tax” since the online retailing giant has been the main target. Some online vendors like Amazon pay sales commissions for ads displayed by website publishers in states where they otherwise have no presence. But states that have already imposed affiliate taxes, including Rhode Island, North Carolina, and Illinois, have found that it simply drove online vendors to cancel these commission arrangements, destroying in-state jobs and tax revenues.

Second, states claim they desperately need the money. Of course, that’s nothing new. States are always looking to plug budget gaps in bad times—and increase their revenues in good times.

Net taxes won’t yield them much. A 2010 study conducted for NetChoice by Jeffrey Eisenach and Robert Litan of the economic consulting firm Empiris LLC revealed that “Total potential uncollected sales tax revenues in 2008 were approximately $3.9 billion, or less than three-tenths of one percent of state and local tax revenues.”

States should find other ways to cover budget shortfalls, including cutting their profligate spending habits. From 2000 to 2009, state and local spending grew at nearly twice the average annual rate as the private sector. Since these governments depend entirely on the private sector for their resources, this level of spending growth is clearly not sustainable.

Third, states say they are trying to “level the playing field” between online and main street retailers. This is a valid concern, but one not well-addressed by the Durbin-Enzi bill. This debate has long pitted “pure-play” online retailers like Amazon.com and Overstock.com against “bricks-and-mortar” retailers, who have an actual physical presence in many states. That is what drives measures such as the “Main Street Fairness Act.”

Better ways exist to level the playing field, however. Cutting taxes on in-state vendors is an obvious solution, but not one many states will likely take up. Relying on other tax bases to fill gaps is another option.

The best fix might be for states to clarify tax sourcing rules and implement an “origin-based” tax system. Traditional sales taxes are already imposed at the point of sale, or origin. If you buy a book in a Seattle bookstore, the local sales tax rate applies, regardless of where you “consume” it. Why not tax Net sales the same way? Under an origin-based sourcing rule, all sales would be sourced to the principal place of business for the seller and taxed accordingly.

State officials protest the vigorous tax competition such a sourcing rule would spawn since some companies might locate their business in more hospitable tax environments. But that’s real federalism at work. Federal lawmakers should favor it over the cozy tax cartel the states want them to bless.